E ARNINGS MANAGEMENT

In accounting theory, earnings management is a much-researched subject and happen when either sales are inflated or expenses deflated in one period, and to be reversed in a later period, to make financial statements appear better. Healy

& Wahlen has often been cited for their definition of earnings management in relation to standard settings:

Earnings management occurs when managers use judgements in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers. (Healy & Wahlen, 1999, p. 368) Earnings management is possible because accounting standards opens for individual judgement where standardisation would be too rigid and not necessarily reflect the true financial value. The judgement is often related to uncertain events such as expected life of fixed assets, future obligations and losses or future value of R&D and marketing.

2.3.1 Motives for earnings management

Healy & Wahlen (1999) presents three different main incentives for earnings management. First, earnings management can be motivated by

influencing expectations of investors and capital markets to affect the value of the company. Dye (1988) presented how managers used earnings management to influence potential investors perception of the firm’s value. Trueman & Titman (1988) explained how managers smooth income to cover the variance of the firm's underlying economic earnings. The authors theorize that this is because managers think that investors value firms with a smooth income stream higher. Burgstahler

& Eames (2006) found evidence for upward earnings management to avoid earnings below analysts’ forecasts.

A second type of incentive to earnings management is to prevent violation of contracts. Financial figures are often used as specific terms in contracts such as debt covenants in a loan contract or management compensation programs.

Managers who change accounting policies in order to avoid violation of debt agreements are documented in several studies. DeFond & Jiambalvo (1994) found evidence that suggests positive manipulation of financial accounts to avoid

violation of debt covenants. The studied firms had positive abnormal total and working capital accruals in the year prior to the violation of the debt covenants.

Sweeney (1994) documents a relationship between changing accounting practices as the firms are approaching the debt covenants constraints.

A third type of incentives for earnings management is related to government regulations, typically imposed by antitrust law or other specific industry concerns. Companies of a monopolistic nature (Cahan, 1992) or

companies engaged in imports (Jones, 1991) could use income-reducing accruals to prevent unfavourable regulations. However, such government regulations are less relevant for small companies with limited importance for industry related or antitrust matters. A more relevant field of research for companies regardless of size are tax related regulations. Guenther (1994) found evidence of earnings management in relation to the Tax Reform Act of 1986 in the United States. The reform reduced the maximum corporate tax level from 46% to 34 %. The author found a significant level of negative accruals in the year prior to the tax rate reduction. In other words, the companies adjust accruals to reduce the profit in the year with the highest tax rate, then increase profits when the tax rate is reduced.

2.3.2 Size management

Another well-documented case of earnings management relates to specific threshold values. Burgstahler & Dichev (1997) examined the distribution of companies with around-zero earnings, and found a higher than expected

proportion of companies just above zero. Although the authors are cautious with drawing conclusions based on their findings, the study illustrates that earning management is occurring around specific thresholds. Bernard, Burgstahler &

Kaya (2014, working paper) expand on this subject by documenting size

management in companies close to audit thresholds in Europe. They theorize that companies manage earnings to adapt to the threshold levels in order to avoid audit. They find a higher concentration of firms just below the threshold values related to revenue, total assets or number of employees. As these results appear in several of the studied countries, it would be interesting to replicate the test on Norwegian companies.

Schipper (1989, p.101) emphasizes that research on earnings management must be interpreted with caution. Many empirical studies find indications of earnings management, but it might be difficult to document the incentives behind the management. In addition, results of earnings management research must be interpreted in light of the limitations and trade-offs made by the researchers.

Results found under special circumstances, in specific geographic locations and of a limited number of observations cannot easily be translated to other contexts.

2.3.3 Identification of abnormal and discretionary accruals

The most common method of identifying earnings management is to analyse accruals. “An effective way to reduce reported earnings in a hard-to-detect manner is to manipulate accounting policies relating to accruals” (Scott, 2012, p.313). Accruals can be divided into discretionary and non-discretionary accruals. Discretionary accruals are determined by the management, while non-discretionary accruals are adjustments regulated by accounting standard-setting bodies (Healy, 1985, p. 89). Further, discretionary accruals are often classified as normal or abnormal. As stated by Healy & Wahlen (1999, p. 370), “To identify whether earnings have been managed, researchers first have to estimate earnings before the effects of earnings management”. The problem is that abnormal accruals are notoriously difficult to separate in the presence of earnings management. A solution, posited by Healy & Wahlen in the same paper, is to identify conditions where managers are likely to have strong incentives for earnings management, and test if the unexpected accruals are consistent with the incentives.

McNichols & Wilson (1988, p. 2) measures earnings management by looking at one specific type of accrual. Provisions for bad debts are compared with an estimate of normal accruals using GAAP. The motive for selecting this

particular accrual was to “attempt to isolate a discretionary accrual proxy that is substantially free of non-discretionary components”.

Instead of estimating only one discretionary accrual, Jones (1991) estimates the discretionary component of total accruals, a model often cited in academic literature (DeFond & Jiambalvo, 1994, p. 158; Dechow, Sloan &

Sweeney, 1995, p. 198; Scott, 2012, p. 313). The author theorize that total accruals will capture a larger part of managers manipulation than one single accrual account. Also included are changes in revenue and fixed assets, in order to define non-discretional accruals. The Jones’ model is based on previous research by Healy (1985) and DeAngelo (1986), but attempts to relax the assumption of constant non-discretionary accruals. Jones estimates non-discretionary accruals as follows:

Equation 1: Jones’ model

Dechow et al. (1995) presents a modified version of Jones’ model, adjusting the revenue component for change in receivables. This modification assumes that all change in credit sales comes from earnings management. Another version of Jones’ model was introduced by DeFond & Jiambalvo (1994),

matching observations of firms from the same year and industry. Such cross-sectional regression relaxes the assumption of a constant coefficient related to year and industry. Kasznik (1999) introduced a further development of Jones’

model including modifications made by Dechow et al. (1995) and Defond &

Jiambalvo (1994) and introducing change in operating cash flow as an explanatory variable.

Instead of estimating the non-discretionary accruals based on different determinants, Dechow & Sloan (1991) presents an industry model assuming that the variation of the determinants is similar for companies in the same industry.

Later, Dechow & Dichev (2002) highlight the importance of the estimation error has on measurement of accruals and earnings quality. They claim previous research have too much focus on the unobservable intentional manipulation by

managers, and suggest accrual quality is systematically related to observable firm characteristics like volatility of operations.